America's Broken Equity Culture

Hulbert On Markets: America's Broken Equity Culture

By Mark Hulbert | 13 February 2010

In the aftermath of 2008, wary investors were even willing to abandon stock mutual funds during the rally of 2009. And that's troubling news for the stock market in the long run. However, mutual fund investors are, finally, beginning to behave more normally. [[Does that mean the top is in!?!: normxxx]]

And, in doing so, they are resolving what has otherwise been one of the biggest mysteries of the bull market that began nearly one year ago: Why did investors respond to a nearly 70% rally by pulling money out of domestic-equity mutual funds? The picture that is now emerging, courtesy of the latest data, is positive for the stock market over the short-term, but worrisome for the longer-term.

Let's start by reviewing the data, compiled by TrimTabs Investment Research. The firm conducts daily surveys of more than 5,500 mutual funds, and therefore has a nearly real-time picture of mutual-fund inflows and outflows. From the March 9 low through the end of 2009, the firm found, domestic-equity mutual funds suffered a net outflow of more than $12 billion.

What makes this net outflow so surprising is that it came in the face of one of the sharpest rallies in stock market history. The Dow Jones Industrial Average, for example, rose nearly 60% over this nine-month period. The S&P 500 index did better still, rising 65%, and the Nasdaq Composite Index even better still, gaining 79%.

By the way, don't think that this unexpected pattern is attributable to investors shifting money from open-end mutual funds into the increasingly popular world of exchange traded funds (ETFs). According to TrimTabs, domestic equity ETFs also suffered net outflows for all of 2009. Even more surprising is the fact that fund investors pulled more money out as the rally progressed. They initially reacted to the rally last spring by pouring modest sums into domestic equity funds. But that trend reversed itself by late summer, and over the last four months of 2009 they pulled substantial sums out.

This is just the opposite of the usual pattern, of course. During the 1980s and 1990s, for example, investors almost universally invested more money in mutual funds as the market rose, and pulled money out as it declined. It is because of that normal pattern that contrarian analysts often point out that fund investors typically buy high and sell low.

Finally, however, fund investors in January reverted to form and began betting on equity funds. Charles Biderman, founder and CEO of TrimTabs, says that fund investors in the two weeks prior to the January market top invested $3.4 billion of new money in domestic-equity mutual funds. "This was the first time we saw two straight weeks of inflows in five months," and suggests that retail-fund investors were, for the first time in a long time, adhering to the general contrarian pattern of buying high.

Fund investors' reaction to the late-January sell-off, furthermore, also adhered to the contrarian pattern. The net outflow of funds, Biderman said, was "brutal": Fund investors pulled out an estimated $15.8 billion in just seven days. In fact, Biderman concludes that the heavy pace of these recent withdrawals is, from a contrarian point of view, "rather bullish" for the market's short-term outlook.

What, then, can we say about last year? Why did it take fund investors so long to begin behaving as contrarian theory expects them to? Biderman believes the answer lies in something he calls "America's broken equity culture," which he says has more disturbing implications for the stock market's intermediate-term and longer prospects. He explains:

"Equity mutual funds investors faced losses of more than 50% twice in the past decade. Equity funds' nominal return is still a little negative for the decade— and hugely negative in terms of gold, oil or any other inflation-sensitive asset— so it will take a long time to rebuild retail investors' confidence in equities as 'the best investment for the long-term'."

Biderman predicts that it will take quite some time for this "broken equity culture" to be "fixed". As a result, Biderman believes that, at least for the next year or two, "mutual funds investors' pecking order" is likely to remain as follows:

1.Bonds

2.Commodities

3.Emerging Markets

4.Non-Us Equities

5.US equities

Since long-term bull-market moves eventually require the participation of the retail investor, therefore, this pecking order suggests to Biderman that we face a sustained period of disappointing returns in the domestic-equity market.